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Beliefs, preferences, and biases investment advisors should know about.
Decision theorist Howard Raiffa [1968] introduces useful distinctions among three approaches to the analysis of decisions. Normative analysis is concerned with the rational solution to the decision problem. It defines the ideal that actual decisions should strive to approximate. Descriptive analysis is concerned with the manner in which real people actually make decisions. Prescriptive analysis is concerned with practical advice and help that people could use to make more rational decisions.
Financial advising is a prescriptive activity whose main objective should be to guide investors to make decisions that best serve their interests. To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that relate to making investment decisions: their occasional faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make. Our article sketches some parts of this picture, as they have emerged from research on judgment, decision-making, and regret over the last three decades.
The biases of judgment and decision-making have sometimes been called cognitive illusions. Like visual illusions, the mistakes of intuitive reasoning are not easily eliminated. Consider the familiar example in Exhibit 1. Although you can use a rule to convince yourself that the two horizontal lines are of equal length, you will continue to see the second line as much longer than the other. Merely learning about illusions does not eliminate them.
The goal of learning about cognitive illusions and decision-making is to develop the skill of recognizing situations in which a particular error is likely. In such situations, as in the case of Exhibit 1, intuition cannot be trusted, and it must be supplemented or replaced by more critical or analytical thinking - the equivalent of using a ruler to dispel a visual illusion.
Providing timely warnings about the pitfalls of intuition should be one of the responsibilities of financial advisors. More generally, an ability to recognize situations in which one is likely to make large errors is a useful skill for any decision-maker.
We follow a long tradition in discussions of decision-making, which distinguishes two elements:...